Diamonds & Gemstones
Diamonds & Gemstones: brighter long term prospects
After a strong first half in 2008 current conditions in the diamond market are tough. Retail sales of diamonds, a discretionary purchase, have been hit by the economic crisis. The credit crunch has dried up liquidity in the diamond pipeline, which has relied heavily in the past on bank finance. Diamond stocks are high. The producers are cutting back production to support prices and conserve cash, while explorers are battling to find funding. Share prices in the industry are down some 75% over the year.
But the industry has a long history and has survived worse downturns in the past returning leaner and fitter each time. Although the odds may be long the returns on capital in the sector can be huge. For example the world’s largest diamond mine by value, (Jwaneng in Botswana), is reputed to have been the most profitable mine of any type anywhere in the world, with a profit to revenue ratio in excess of 90% (turnover $2bn pa, profit around $1.8bn) Similarly the Marsfontein diamond mine in South Africa produced such wonderful stones at the outset that it recouped its exploration and development costs within five days of production.
It is also an industry with a potentially bright future as there is a widespread belief that there will be future supply shortages due to the combination of increasing demand from the emerging markets but constrained supply (there are only 20 years of known diamond reserves left in the ground). Moreover today’s difficulties could make the future rough shortages more acute and the upswing, when it comes, more favourable.
Before looking in detail at current prospects for the sector here’s a quick review of the basics of supply and demand.
Fundamentals of Diamond Supply and Demand
Diamonds were formed billions of years ago from carbon crystallised at great pressure and heat in the earth’s mantle some 150km below the surface. The ‘elevators’ which brought them and other minerals to the surface were pipes of molten rock known as kimberlites. To date some 7,000 kimberlites have been found, though fewer than 1,000 of these are diamondiferous, and just 30-50 have included sufficiently viable quantities to become diamond mines.
Although kimberlites are the primary source diamonds are also found in secondary deposits where the stones have been washed away from the host kimberlite pipes and concentrated by water action in either alluvial (river) deposits or in marine deposits on the sea floor or beaches. While kimberlites are generally the biggest and most profitable mines alluvial diamond projects, which tend to be small to medium size, nonetheless have a number of advantages. They have a low capital cost, equipment can be reused and they can generate cash relatively quickly, even just 18 months after initial exploration. Also they often enjoy a high value per stone, as only relatively large diamonds are found. Note that diamonds are unlike other commodities as each stone is unique. Depending on the size, colour, quality (and cut for polished diamonds), the price can vary from a few dollars to $50,000+ per carat (a carat is 0.2g). This means that any comparison involving carats needs to be treated with care as the value of each carat is also crucial.
Diamond production is geographically concentrated, with just 9 countries accounting for 97% of annual output. Botswana is the largest producer by value, with a 24% market share and in total more than 60% of world production comes from Africa. The picture in carats is quite different because of the enormously different stone size profiles of the countries; the average $/ct in 2007 ranged from $722 in Lesotho to just $13 in the DRC (and the range from individual mines can be far greater than this).
Historically output has also been concentrated in the hands of a few majors including De Beers, the Russian company Alrosa, Rio Tinto, BHP and Harry Winston. Together they have typically accounted for around three quarters of world production, though the share is changing as a number of new producers, such as Gem Diamonds and Petra Diamonds, have come onstream in the last few years on the back of the favourable long term fundamentals in the diamond market.
Demand-wise diamonds have been desired for centuries, or even millennia, because of a combination of their history and their physical and emotional properties. Physically diamonds are the hardest substance in the world, they have high thermal conductivity and a number of optical properties including high brilliance, refraction and lustre. Emotionally they have been seen as a symbol of love, prestige and beauty for many years, and of course there have also been a number of memorable expressions associated with diamonds. “A diamond is forever”, coined in 1947, was named the best slogan of the 20th century by Advertising Age, while everyone knows that diamonds are a girl’s best friend. Indeed it has been pointed out that diamonds have achieved almost universal product recognition. About 90% of the value of diamond production is polished in the diamond cutting centres (such as India, Israel, Antwerp and New York) and used in jewellery, with the remainder being used for industrial purposes such as drilling, computer chips and stone-cutting.
Diamonds are owned by hundreds of millions of women around the globe though there are significant differences between countries in the size and qualities demanded, in the types and designs of jewellery sold, and in the relative importance of the gift/self-purchase market and in the occasions/rites of passage for which diamonds are acquired.
Recent Developments in the Diamond Market
Until fairly recently there was widespread optimism in the diamond market about future long term supply-demand fundamentals with an expectation that the industry was on the cusp of moving into an era of supply shortage and rising prices. Many presentations were given by many companies showing a chart similar to the one below, which shows BHP’s view of future the global supply/demand balance at the time that it was presented in 2007. On the one hand demand was expected to rise steadily driven by ongoing demand growth from the US, (the world’s largest market accounting for almost half of world demand), and strong growth from the newer diamond markets of India, China and the oil states. On the other supply growth was expected to be constrained by the combined effect of declining production at several maturing mines, the lack of new major discoveries in recent years and the long lead times to build a large mine.
At the beginning of 2008, although there were plenty of challenges facing the industry, the prevailing view was still one of rising demand but supply constraints. Rough prices duly rose some 15-25% during the first half of the year.
Since September 2008 however there has been a sea change. The economic crisis has hit the retail sales of diamond jewellery in the all-important Christmas season by more than was anticipated in the market. This, as always, has had a far greater impact on the rough market because the effect is amplified by the large pipeline inventories required to support the many different types of diamonds and diamond jewellery. On this occasion it has been made even worse by the credit crunch and lack of liquidity. Sales in the rough market have been decimated and prices are down some 30-50%, though prices of polished diamonds have fallen far less.
The diamond sector has responded in a number of ways. Many producers have announced cutbacks. De Beers for example has embarked on a programme which will reduce output “significantly” this year, Rio Tinto has cut output at Argyle mine in Australia, shut its diamond processing facilities for up to three months for maintenance and delayed the mine development programme at Argyle, its biggest mine, while Alrosa has stated that it will sell significantly fewer diamonds this year. The exploration and small and mid-tier producers companies meanwhile are looking at new funding routes such as sales agreements, private equity, development agency funding and Middle Eastern capital in order to survive. The mood now is very subdued in the market and 2009 is expected to be very challenging.
In the meantime the equity markets have hammered the sector. The market cap of the 24 diamond companies listed on the London Stock Exchange has fallen 75% from £1.8bn at the end of 2007 to £485m by the end-08. The flip side of that of course is that companies are now at historically very cheap levels and, arguably, there are still some grounds for optimism.
· De Beers has commissioned and published a report on luxury goods suggesting that in the current climate consumer are growing fatigued with mass marketed luxury products and will gravitate instead towards fewer but better things. Buy less but buy better! This may favour purchases such as diamonds which can be enjoyed for a lifetime and passed down generations.
· The company announced that it will unveil a new “big idea” later this year to drive diamond category growth.
· In previous recessions sales of ‘rites of passage’ jewellery such as diamond engagement rings, have generally held up.
· Since diamonds are available in every size and quality there are stones for every budget
· There is still plenty of scope for further demand growth in the emerging markets.
· The outlook of future supply constraints has not gone away. Indeed it has been made more likely after the recent setbacks and exploration cutbacks.
· History has suggested that when a rebound comes in diamond prices it comes quickly and sharply. Surpluses turn very quickly into shortages and this could be exacerbated by the production cutbacks. It could be argued that the foundation for a strong recovery in diamond prices is being laid.
Perhaps the most widespread view now is that the long term prospects are still favourable but the timing of any supply deficit has been pushed out. Meanwhile the short term will be extremely challenging, and as Gareth Penny, Managing Director of De Beers, pointed out the problem with the long term is “getting there …... without action in the short term there can be no success in the long term”.
So in the short term cash will be king. The market will favour cash, production, innovative financing solutions and companies with sound projects which are viable at lower prices. Potential takeovers could be attractive.
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